The mainland will need to devalue the yuan this year to carry out financial system reforms promised at the recent National People's Congress, according to Deutsche Bank. A devaluation would offset the economic pain brought about by a clean-up of a financial system which Deutsche describes as the 'weakest in the region'. Deutsche adds its voice to similar calls, including one by Harvard economist Jeffrey Sachs, who recommended a devaluation in a speech in Hong Kong yesterday. Just as many economists say a yuan float would do more harm than good - that a slight increase in export competitiveness would come at the cost of potentially destabilising the region and bankrupting mainland investment trust companies having to repay foreign currency loans. Deutsche's argument, put forward by its Asian economists Angus Armstrong and Michael Spencer, is based on one of the harshest evaluations of the mainland financial system. By Deutsche's estimates, 50 per cent of loans in the system were non-performing and the costs of recapitalising banks would reach 40 per cent of gross domestic product. In comparison, South Korea - which accepted a US$58 billion International Monetary Fund bailout after its economy imploded in 1997 - saw non-performing loans peak last quarter at just 30 per cent by the highest estimates. 'The [mainland] financial system is the weakest in the region, highly reliant on credit from seriously undercapitalised banks and lacking . . . a credit culture in which debtors are compelled to pay, and creditors are entitled to returns from capital,' Deutsche said. A clean-up of the mainland banking system could not be done without substantial reforms to the state enterprise system - Deutsche estimated the costs of such structural reform would add the equivalent of 6 per cent of GDP to the annual budget. As a result, non-essential spending would be scaled back and the constraint on state enterprises - more than half of which were loss-making - would add more unemployed to the swelling ranks of jobless. 'It is inappropriate for China to maintain a fixed exchange rate while its economy is subject to such profound structural changes,' Deutsche said, predicting a more flexible exchange rate policy would be put in place by the end of the year. 'An initial devaluation of the [yuan] will be necessary to provide a counterbalance to the initially contractionary impact of reforms.' The bank did not say how much the yuan would decline but indicated it would probably be less than 13 per cent. The private sector would benefit the most from a float - and it was the private sector which would absorb new employees as the economy evolved. Deutsche conceded that its argument started from the premise that mainland authorities would vigorously pursue their promised reform agenda - risking a political and social backlash. At the recent National People's Congress and at other times this year, senior officials have said the mainland would change accounting practices to recognise growing non-performing loans, and would create a financial restructuring agency. The China Construction Bank has initiated a pilot scheme - based on the United States' Resolution Trust Corp - in which non-performing loans could be repackaged as asset-backed securities. Other analysts argued that just because the mainland needed to reform its banks did not mean it would do so. CLSA Global Emerging Markets economist Jim Walker has said the regional crisis slowed momentum for mainland reform. He said Beijing had turned to fiscal spending - not fiscal reform - in an ill-fated bid to buy itself out of economic problems. CLSA expected a yuan devaluation of 10 to 15 per cent this year, but said it would be done as a last-ditch strategy as the failure of its fiscal-spending plan became apparent.